Streetwise Professor

May 5, 2010

Clearing Currencies

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:03 pm

The European Commission is pushing for foreign currency derivatives to be cleared.  This is also a bone of contention here in the US.

It is interesting that those advocating clearing, and also exchange trading, have not attempted to explain the very pronounced cross sectional variation in trading and clearing practices across markets, and the time trends in particular markets.  Virtually all FX derivatives trading is OTC (with currency futures being the hair at the end of the tail of the dog).  The large bulk of linear interest rate derivative trading is OTC (even though the Eurodollar futures and similar markets are immense, they are dwarfed by the even more immense OTC interest rate swaps).  Equity derivatives and interest rate option trading is more evenly split between OTC and exchange.  Moreover, whereas in recent years a good portion of interest rate swap business has migrated to clearing naturally (accounting for about 50 percent of the interbank business), no OTC FX business is cleared.  A decent amount of OTC equity business is cleared.  A considerable part of OTC energy trading in the US is cleared–and was trending in that direction starting from about 2003 without anybody from the government telling market participants to do it.

The lack of clearing in OTC FX is pretty interesting, inasmuch as counterparty risk on an FX swap of a given amount and tenor is greater than that of a corresponding interest rate swap because principal is at risk in the former, but not the latter.  If clearing is such an economical way of allocating counterparty risk, why is it almost completely absent for products in which that risk is pronounced?  Similarly, due to the jump-to-default feature in CDS, these products pose large counterparty risks, but they weren’t cleared either until the dealers came under pressure to do so.  So, the instruments that arguably pose the greatest counterparty risks were not cleared voluntarily.

It would be nice of those who have the Olympian insight to dictate how markets should be structured could explain how they are structured.  If the European Commission is right, then the participants in the FX derivatives market are wrong.  Why?  And why should FX market participants choose a different mix of execution and counterparty risk allocation methods than participants in interest rate swaps and equity and energy derivatives?  Especially since there’s more than a little overlap between the participants in these various markets.

This is an interesting economic puzzle, the solution to which might, just might, be somewhat illuminating.  It might just shed some light on the economic trade-offs involved in clearing.  Just a guess.  But in the haste to prescribe–to dictate–market structure, our legislative and regulatory betters couldn’t be bothered to understand.  They just know.  So everybody should just shut up and get with the program.

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  3. Derivatives under public scrutiny (exchange traded), should be “cleared”. But otherwise counterparty risk should have been discounted “up front”.

    Comment by flow5 — May 6, 2010 @ 1:20 pm

  4. History has a lot to do with it. If the frictional cost of moving from an OK arrangement to a better one is larger than the benefit, the status quo persists. This is particularly so if the estimates of both sets of costs is uncertain, making the judgement risky. Finally there is a problem whereby first movers lose the value of their investment in the new market if an initiative does not take off, and they need a critical mass of other market participants before it will.

    Comment by David — May 6, 2010 @ 1:32 pm

  5. @David. Agreed, for the most part, and I’ve made similar points in my academic writing. But the important thing is that there are costs, a basic point that is missing in the current debate. Also, unless there are cross sectional variations in these costs of moving, it is hard to explain the cross sectional variation in the penetration of exchange trading and OTC clearing across products. This suggests that there are cross sectional variations in benefits too. Either cross sectional variations in costs or benefits, moreover, would undermine the case for a one-size-fits-all approach to market structure that is inherent in mandates.

    The ProfessorComment by The Professor — May 6, 2010 @ 2:34 pm

  6. I don’t actually know, but it seems logical that if the counterparty risks are very large (as you say is true of FX swaps) then the problem may be that there is no party willing to step forward to perform the clearing function for these transactions.

    In other words, this situation may not be caused by the trading parties’ preferences at all.

    Comment by Karen — May 6, 2010 @ 10:22 pm

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